This Stock Is Cheap -- or Is It?

Genentech (NYSE:DNA) is one of the truly remarkable success stories of the past 15 years. More than a decade after its IPO, Genentech was still a small company that had not yet scratched the surface of its potential. On Nov. 10, 1993, Genentech traded for $5.92. It now trades for more than $83.

That more than 1,300% gain illustrates the profit potential of investing in promising small companies. It also goes to show that if you want Genentech-like gains, you need to look for stocks trading around $5 per share -- if not less. Just take a look at this list of winners since 1993 and their stock price back then:

Say it with us: No, no, no!
Here's where we pull back the curtain: All of those Nov. 10, 1993, prices are adjusted for stock splits and -- in some cases -- dividends. While Genentech was a small company back in 1993, it still traded for $47 per share. Intel traded for $63, Applied Materials for $37, Qualcomm for $75, and Linear Technology for $35.

So, we hope we've done a little bit of myth-busting here. Namely:

1. Lower-priced stocks do not rise any faster than higher-priced stocks.
2. Lower-priced stocks are not necessarily cheaper than higher-priced stocks.
3. Lower-priced stocks are not necessarily smaller than higher-priced stocks.

By itself, a stock's price cannot tell you anything about the value of the underlying company or its investment potential.

That's why Middleby, a stock that's returned more than 290% for subscribers to our Motley Fool Hidden Gems small-cap service, can remain a promising $620 million small cap, even though it trades for more than $35 per share. It's also why Ford (NYSE:F) can continue to look like a struggling $4.4 billion company, even as it trades for less than $2.00.

You cannot beat this price
Myths about the meaning of stock prices abound, and catering to those myths may be one of the reasons Middleby split the company's shares last year. But we encourage Middleby's leaders to stop worrying about the stock price, save the time and money required to file the necessary stock-splitting paperwork in the future, and instead continue to focus on allocating capital efficiently and growing the business for the long term.

That's what long-term shareholders should care about. If the business is succeeding, the stock will follow -- whether it's starting from $5, $50, or $500.

The Foolish bottom line
We readily admit that small companies, as measured by market caps of $2 billion or less, are likely to offer better returns than large companies going forward. So, if you're looking for stocks with the most potential for outsized returns, start with small caps -- you'll find that a more productive starting point than "low-priced stocks."

Also, look for key traits of the market's biggest successes:

1. Cheap valuations relative to a company's earnings or cash flows.
2. Tenured managers who own a significant number of shares.
3. Growing operations in a profitable niche.

And if you can find a company that meets these criteria, it's worthy of your research, no matter what the stock price. After all, this simple framework is often how we start our research at Motley Fool Hidden Gems. It helped us find Middleby and many more recommendations that are, in aggregate, beating the market since we started in 2003.

If you'd like to take a look at the stocks we're recommending today, click here to try Hidden Gems free for 30 days. There is no obligation to subscribe, and you might just find a bargain trading for $50 per share.

This article was originally published on Feb. 13, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned; Brian Richards doesn't own any, either. Linear Technology is a Stock Advisor selection. Intel is an Inside Value recommendation. The Fool owns covered calls on Intel and has a disclosure policy that would like to remind you that when in Rome, price is what you pay.